Data and Bond Yields Point to a Modest Recovery

Today's economic data is further evidence that the economic recovery is a modest recovery. The Chicago Fed report (which includes the Detroit automakers) was somewhat disappointing (along with a downward revision of the previous report), but the remaining data was very close to the street consensus (itself only mildly optimistic). Equity market bulls continue to point to corporate profits as evidence that the economy is about to take off. The problem with that assessment is that corporate profits are string precisely because companies can to more with fewer workers. It is going to take economic activity last seen during the overstimulated bubble just to get to acceptable levels of unemployment (around 6.00%). Housing is the key.

Why is housing the key when the sector itself is responsible for a relatively small part of the U.S. economy? It is because a strong housing market makes consumers feel more confident and, more importantly, it gives consumers the home equity necessary to spend to fuel the economy. Wage growth has been lack luster during the past decade, yet consumers were able to spend on cars, TVs, home remodeling and new homes all due to leverage. That game is over.

The new game will be centered around income and not just wages, but the amount of money people take home. The fixed income markets are keenly aware of the economic policies which are coming down the pike. The are not conducive to greater disposable income. Taxes on wages, dividends and capital gains are all going to rise. The estate tax will return.

Credit will not make a comeback anytime soon either. First: Banks cannot lend as they had in the past because they cannot easily lay off the risk via securitization as they had during the last expansion. Secondly: Banks have little incentive to lend and keep loans on their books. By doing so they take risk, could be held liable should the government look unfavorably upon lending practices or loan provisions. Lastly: Banks can make more money via the carry trade in riskless treasuries.

Some economic apologists now exclaim: "If not for Greece" or "If not for Europe the economy would be rebounding strongly." The miss two points. First: The crisis overseas is actually helping U.S. credit and borrowing by keep interest rates low. Secondly: There is no U.S. credit market or European credit market. There is one global market for credit. This is more evidence that there is no such thing as decoupling in this era of globalization. The G20 meeting proved that. Those decoupling proponents were either shortsighted or disingenuous about there true economic views hoping to jawbone the markets higher. The only other option is that they are not all that bright.

Where do we go from here? Get the idea of significantly higher interest rates out of your head, at least for another year, probably two. Floaters will continue to disappoint investors, but step-ups and higher coupon debt instruments should do well. Equity markets should trade mostly sideways, but companies will need to continue to post healthy profits just to maintain current equity price levels.

Many readers ask me what should they look for as a sign the economic outlook is improving. I would be looking at the yield of the 10-year treasury. As the global economic outlook, investors who can leave the safety of U.S. treasuries and invest in riskier asset classes. Please manage your expectations however. The global economy is not likely to recover sufficiently to result in a wholesale exodus from U.S. treasuries, but today's closing yield of 3.02% is far too low to persist in a healthy global economy. Current long-term interest rates indicate that the bond market knows there is at best a persisting economic malaise or at worst a double-dip recession. I believe that it will be the former. In the end it comes down to fundamentals.

This should be a relatively slow week in the capital markets. The forthcoming Independence Day weekend has many market participants at the beach, in the mountains or on the golf course. Next week will be no better. Thin markets usually result in heightened volatility. The market is focused on this week's employment data. The street consensus is calling of a loss of 115,000 jobs an an unemployment rate of 9.8%. Not exactly the stuff of economic expansion.

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